Tarvale is a major quoted company that manufactures timber products. The company has suffered a major setback during the past few months. The company$$s largest supplier was unable to meet Tarvale$$s timber requirements because of volcanic activity close to the supplier$$s forecasts caused forest fires which severely disrupted transport routes. Tarvale was able to purchase timber from alternative sources but paid much more than usual because Tarvale receives a substantial discount from its usual supplier.

Most of Tavarle$$s board members are concerned that the shareholders will blame them for allowing the company to become so heavily dependent on a single supplier. The Production Director disagrees, though, on the basis that the Capital Asset Pricing Model $($CAPM$)$ suggests that shareholders diversify, which protects them from unsystematic risks. The Vulcanic disruption is an unsystematic risk and so the shareholders were protected. In any case, the Production Director had considered the risk of disruption due to the volcano and had concluded that the risk of an eruption in any given year was less than $5\%.$

Tarvale has a high gearing ratio. The Production Director proposes that the board should determine the company$$s ungeared beta to determine whether the shareholders are earning a satisfactory return on their investment, despite the costs associated with the volcano.

i$)$

Discuss the Production Director$$s argument that holding diversified portfolios would have protected Tarvale$$s shareholders from the volcanic disruption and so the shareholders will not blame the board. $[8$ marks$]$

ii$)$

Discuss the Production Director$$s proposition that the risk had been evaluated and so the board should not be criticized. $[7$ marks$]$

iii$)$

Discuss the respective relevance of Tarvale$$s geared and ungeared betas to its shareholders. $[5$ marks$]$